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Trang 4ETF TRADING STRATEGIES REVEALED
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All rights reserved.
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TABLE OF CONTENTS
CHApTER 1: First Things to Know about
CHApTER 2: Valuable Advice from Linda
CHApTER 3: Steve Palmquist &
pART III: MECHANICAL ROTATION STRATEGIES 20
CHApTER 6: Sector ETF Rotation Using Style
CHApTER 7: Sector ETF Rotation Research 31
pART III CONCLUSION:
CHApTER 9: Dr J.D Smith Offers a Personal
page
TABLE OF CONTENTS
CHApTER 1: First Things to Know about
CHApTER 2: Valuable Advice from Linda
CHApTER 3: Steve Palmquist &
pART III: MECHANICAL ROTATION STRATEGIES 20
CHApTER 6: Sector ETF Rotation Using Style
CHApTER 7: Sector ETF Rotation Research 31
pART III CONCLUSION:
CHApTER 9: Dr J.D Smith Offers a Personal
Trang 6ETF TRADING STRATEGIES REVEALED
money could you make?
Introduction
This book presents a revolutionary
approach to making money using
classic technical analysis trading
techniques How can something
be both revolutionary and classic?
We apply classic technical analysis
techniques to a new and growing
investment vehicle—the
Exchange-Traded Fund
Many books claim to reveal
revo-lutionary new trading techniques
Like fad diets, these techniques
slowly fade away to be replaced
with other “new and improved”
systems The approach in this book
is different We apply classic
tech-nical analysis techniques that have
worked in the past and because of
their simplicity will continue to
work in the future
The techniques and mechanical
trading systems covered in the
book are easy to learn and can be
successfully employed by most
people That doesn’t mean this
material is bedtime reading Using
a highlighter and a notepad would
be appropriate
The book is divided into four parts
Part I describes what ETFs are and
how they work It includes all that
is needed to start succeeding in ETF investing
Part II details the classic technical analysis technique of using chart analysis to trade ETFs Both short-term and longer-term methods are discussed
Part III covers simple but highly effective mechanical ETF rotation techniques These techniques are applied to the different categories
of ETFs (style, sector, and national) that are now available to the individual investor
inter-Part IV takes a brief look at ing psychology While we offer several highly effective techniques, they work best when tailored to your personal trading style and when you have the emotional discipline to follow them This is
trad-an importtrad-ant subject trad-and is often ignored, to the detriment of many traders
In creating this book, our goal was to include all the relevant material necessary for trading of ETFs, while leaving out the fluff
We attempted to incorporate in this book as much useful informa-tion as one would find in a book ten times its size We believe our mission is accomplished We think you’ll agree
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Trang 7page
Part I
THE BASICS
OF ETFs
Part I is a brief description of
Exchange-Traded Funds and how
they work—all you need to know
to successfully trade them
Exchange-Traded Funds (ETFs)
are the fastest growing financial
product in the United States
While still small, many expect
they will eventually overtake
mu-tual funds in assets Mumu-tual fund
companies are aware of this and
the largest fund families—Fidelity
and Vanguard—have introduced
their own ETFs
If you desire more detailed
information, check the web sites
that we list near the end of the
book For more comprehensive
books on the subject, see Appendix
I: Recommended Reading
Chapter
First Things to Know about Exchange-Traded Funds
Exchange-Traded Funds (ETFs) have exploded in popularity Outside of Wall Street, however, few
people know what they are That is changing In time, ETFs will be as commonly known to people as mutual funds are
ETFs were introduced in the United States in 1993 with the advent of the Standard & Poor’s Depository Receipt, commonly known as S&P 500 Spyder (SPY) ETFs didn’t become well known, however, until the late 1990s when the very popular Nasdaq 100 ETF (QQQQ) was introduced Investors have quickly learned that ETFs provide a convenient way to gain market exposure to a domestic sector, a foreign market, or a com-modity with one single transaction
As a result, ETFs have become the fastest growing financial product in the United States By the end of 2005, the number of publicly traded ETFs was about 200 with assets of around $300 billion
ETFs are securities that combine elements of index funds, but do so with a twist Like index funds, ETFs are pools of securities that track specific market indexes at a very low cost Like stocks, ETFs are traded on major U.S stock exchanges and can be bought and sold anytime during normal trading hours Buy and sell orders are placed with any brokerage firm Many of the execution tactics suitable for stocks can also be applied to ETFs, from stop and limit orders to margin buying They can be shorted and often have options listed on them
Trang 8In-Owning a basket of securities is
much more comfortable than
own-ing a few individual stocks With
ETFs, you don’t have to worry that
your stock holding will gap down
20% after an unexpected profit
warning is issued Because of their
diversification, the price movement
in ETFs is more predictable than in
individual stocks
The strategies that will be outlined
in this book are tactical in nature
and are intended to strengthen
a portfolio by diversifying it, yet
channel the diversification toward
specific, outperforming market
sectors
COSTS
When it comes to running an
investment fund, there will always
be costs These costs can include
analyst fees, marketing costs, and
administrative costs Generally,
index funds are cheaper to manage
than actively managed funds Since
most ETFs are index funds, their
expenses are generally well below
those of actively managed mutual
funds Even when you compare
similar products, ETF expenses are
generally lower For example, the
Vanguard Index 500 has a very low expense ratio of 0.18% of assets, but the iShares S&P 500 ETF is cheaper still, with an expense ratio
of 0.09%
The biggest cost advantage of ETFs over traditional index mutual funds is in back-end expenses In-dex mutual funds have to maintain the individual account balances and mail statements and must have
a staff ready to open and close
ac-counts With ETFs, these expenses are eliminated, making funds cheaper to manage
To be fair, there may be overriding reasons favoring mutual funds for some investors For example, if you invest small sums at regular inter-vals then mutual funds are more appropriate Because ETFs trade like stocks, investors pay a broker-age commission each time they buy
or sell, making them expensive for
people who add regularly to their investments Mutual funds are also able to re-invest quarterly divi-dends, an advantage for those who buy-and-hold
TAxES
ETFs are typically more tax ficient than mutual funds Mutual funds sometimes have to sell hold-ings to meet the need of redemp-tions, which triggers a capital gain distribution for all fund sharehold-ers Anyone who bought a mutual fund in early December and ended
ef-up paying taxes on other people’s gains knows that’s no fun!
With ETFs, shares are bought and sold on the open market so if one investor cashes out it doesn’t affect others The after-hours trading scandal in mutual funds doesn’t apply to ETFs
LIquIDITy
Before assessing liquidity we need
to understand what liquidity is and why the lack of it is a bad thing
A liquid investment is one that can quickly be bought and sold at its fair market value Individual purchases and sales of the security
Source: AIQ Systems
Comparison of S&P Small-Cap 600 Value Index (upper chart) and the iShares S&P 600 Value ETF (lower chart) Comparison shows how closely the ETF tracks the index.
F igure 1- AIQ CHARTS
Trang 9page
should not affect its price Liquidity
is generally measured by the
num-ber of shares traded per day
Thinly traded securities are
con-sidered illiquid As a result, they
have high spreads (the difference
between the bid and the ask prices),
which adversely affects the
execu-tion cost Trading illiquid
invest-ments can be expensive
Since ETFs trade like stocks, it’s
reasonable to assume their
liquid-ity should be judged in the same
manner as stocks That’s a common
misconception about ETFs, even
among Wall Street professionals
Unlike stocks, the number of
shares in an ETF is not fixed That
is, if the demand for a given ETF
outstrips supply at any point, then
a specialist may simply create new
shares from a basket of the
under-lying securities in that fund Shares
are created or redeemed to meet
demand Therefore the liquidity of
an ETF is not only defined by its
volume, but also by the liquidity of
its holdings So you might see an
international emerging market ETF
with a lot of volume that is actually
less liquid than a domestic
large-cap value ETF that trades with lower volume
If an ETF and a stock both have 30,000 shares traded on a particu-lar day, the ETF will typically be more liquid That is, your order is much less likely to move the price
In a few cases, block orders that I placed were more than half of the total volume for an ETF on a par-ticular day Expecting that it would take a long time to get a fair execu-tion, I’ve been pleasantly surprised
to get immediate execution at the market price
For the typical investor, this should
be comforting It doesn’t mean, however, that shares are created
or redeemed for your order This process is typically done for insti-tutional investors that trade 50,000 shares or more The party on the other side of most ETF transactions
is a market maker or another tor For most retail orders, a market order is sufficient The bid-to-ask spreads in ETFs tend to be narrow and cover a large number of shares
inves-With that said, buying or selling ETFs with high daily volume is more attractive (in terms of spread) than trading ETFs with low vol-
ume Unfortunately, many ETFs don’t trade very much Active trad-ers should stick with the ETFs like the S&P 500 SPDR (SPY), Nasdaq
100 (QQQQ), or Russell 2000 (IWM), all of which have high vol-ume and narrow spreads
When you place an order for a low volume ETF, don’t use a market order Instead, place a limit order between the bid and the ask price
Unless it is a fast moving market, you’ll almost always get a quick execution
NEW DVD
ETF Trading Tactics:
Using the Power of the Market to Make Money
David Vomund
David Vomund’s 90-minute presentation gives you everything you need to get started in trading ETFs Vomund’s rock-solid and simple strategies for evaluating and rotating ETFs will have you on your way to profiting in no time
go to - www.traderslibrary.com
Trang 10Chapter
valuable Advice from Linda Bradford raschke
Linda is president of LBRGroup, a CTA firm that manages money in both futures and equities She is
featured in Jack Schwager’s book, The New Market Wizards, and co-authored the best selling book
Street Smarts—High Probability Short Term Trading Strategies
The following is an interview that I conducted with Linda focusing on methods for trading ETFs
Vomund: Is it worth day-trading ETFs?
Raschke: In my opinion, no There are far better vehicles for day-trading Either futures or higher beta stocks
are better The problem is that few ETFs have the volume and liquidity for fast and effective execution, and the ones with sufficient volume tend to be the slower movers
ETFs are so broad and encompassing that they can be classified into two groups A small number of ETFs are heavily traded and very liquid, such as Spyder (SPY) that tracks the S&P 500, but most aren’t liquid enough for active day-trading Many global and sector ETFs might only trade 50,000 shares a day
The vehicle you choose to use for day-trading depends on your execution platform, your commission ture, and your objectives I know people who successfully trade the Spyder (SPY), but most professional day-traders will choose the E-mini S&P Futures instead because of the greater leverage
struc-The advantage of ETFs is that they cover such a broad spectrum struc-They allow investors to easily buy equities from many countries or individual sectors And because an ETF contains a basket of stocks, one bad apple
is usually offset by the other stock holdings When you trade a basket of stocks, you’ll do better trading a longer time frame as opposed to a shorter time frame Longer time frame charts show smoother price move-ment and less noise
Vomund: So professional day-traders typically aren’t interested in trading ETFs How about the trading
investor? By that I mean someone who doesn’t follow the market throughout the day but places trades with a holding period of several days to a few weeks
Linda Bradford Raschke
Part II
CHArT
AnALySIS
Part II covers the important topic
of chart interpretation For help,
I’ve turned to two technicians that
I very much admire Both are
professional traders who strive
for consistency—their goal is to
make money in all market
environ-ments At the core of their analysis
is chart pattern interpretation
“The chart tells all.”
Linda Bradford Raschke actively
trades equities and futures She
explains how the same analysis
techniques are successfully applied
to trading ETFs While the
tech-niques may be the same, she
ex-plains how ETFs should be analyzed
under different time horizons
Steve Palmquist’s contribution is a
market adaptive approach He
varies his style of analysis based
on the market condition His
article details his approach to
trading, including buy, sell, and
capitalization rules
Trang 11page
Raschke: The more volatility and
liquidity an individual market has,
the shorter the time period that you
can trade and use for your analysis
With ETFs, I’d use daily and weekly
charts exclusively and turn off the
real-time charts If you placed an
order on many of the foreign market
ETFs, you might as well execute the
order on the open or the close
be-cause these ETFs don’t trade much
throughout the day
Still, whether you use intraday
charts or weekly charts, you
al-ways go through the same process
of determining if you should be a
buyer or a seller, determining
sup-port and resistance, determining
the trend, determining
consolida-tion points, etc The foreign ETFs
were some of the best investment
vehicles last year
Vomund: What methods do you
use to time your entry points?
Raschke: Because ETFs hold
bas-kets of stocks and are more
diversi-fied than individual stocks, they
respond very well to simple chart
analysis I believe that there are
no more powerful tools than the
techniques that have been written
about in classic technical analysis
literature I trade the basic chart patterns like the triangle I trade breakouts, and I trade pullbacks after breakouts
This is simple stuff but it is all that
is needed to be successful, and it eliminates a lot of the noise in the market when the techniques are applied correctly Watch the previ-ous swing highs and swing lows as well as the length of the swings up and down when timing entries
Vomund: Can you give some
ex-amples?
Raschke: Sure Because it has had
lots of movement, let’s look at the weekly chart of iShares Japan Fund (EWJ) (Figure 2) It is easy to notice that during 2000-03 all the major swings were greater to the down-side than the upside Notice the lower highs and lower lows
Within this time period there was a drop in 2001, followed by a reaction move to the upside (point 1) Since the trend is down, traders should short into this reaction A second leg down ensued in 2001 followed
by another reaction up The tion was also a classic ABC type move (rallies to point A, falls to a
reac-higher low in point B, and rallies above point A to point C) with a classical momentum divergence on the way up (see trendline on mo-mentum indicator) This is one of the best shorting signals that you can get
The last leg down had a clear loss of momentum, as the drop was not as great as the second leg lower As a result, a positive divergence formed
in the momentum indicator That
is, the oscillator made higher lows
Then in June/July 2003 there was
a very sharp spike up This was the first swing greater in the opposite direction than the previous down-swing As it was much greater than the previous swing high, the sum-mer swing high showed that the market had changed its character You now switch from shorting reac-tions to buying pullbacks
Beginning in the summer of 2004, EWJ began to drift After the breakout from the triangle, you
Source: AIQ Systems
Weekly chart of iShares Japan fund with Momentum indicator plotted in the lower window The time period is 2000 through 2005.
F igure 2 - EWJ 12/30/05
Trang 12can see at point 2 that momentum
made new highs confirming the
breakout An uptrend was in place
so traders should now buy the
pullbacks
Weekly charts display longer-term
moves and, as they filter out a lot of
the market noise, they tend to show
smooth and consistent swings
They are very easy to read, but their
analysis will not provide many
trades More active traders can
perform the same style of analysis
a gap or a large range increase with increasing volume With EWJ, there was a large gap on August
10 with heavy volume If you don’t see the start of the uptrend on the chart, you certainly will on the mo-mentum indicator (point 1), where the oscillator far exceeded its previ-ous high points Daily chart traders can begin to trade the pullbacks after this new momentum high
It is important to choose ahead of time what side of the market, long
or short, you will play That’s how you work most efficiently In the case of the Japan Fund, you look to short the reactions until mid-2003, and then you look to buy the pull-backs once the trend has changed
You don’t want to work both sides
Instead, work the side with the most potential gain
Vomund: Taking advantage of
pullbacks against the overall trend
is an important part of your egy Is there a certain moving aver-age that you like to see the security pull back to?
strat-Raschke: Moving averages can be
tools for your eye to spot pullbacks, but there isn’t an optimal mov-ing average that works best I use a twenty-period exponential moving average as a default, though
Vomund: At what point during a
reaction against the overall trend should you enter a trade?
Raschke: That depends on how
aggressive or conservative a trader you are An aggressive trader might initiate a small-scale entry if he perceives a slowing of the reac-tion, whereas a conservative trader should wait until the market starts
to turn back toward its trend It also depends on the liquidity of the security In a less liquid market,
a trader will get a more geous price entering a long posi-tion when there are lots of sellers and vice versa In other words, you should try to enter before the security turns, as long as you are still confident that you are trading
advanta-in the direction of the higher time frame trend
Vomund: Do you limit yourself to
trading just the first two or three pullbacks, figuring that at that point a true trend reversal is due?
Source: AIQ Systems
Daily chart of iShares Japan with Momentum plotted in the lower window
Arrow points to upside breakout from triangle pattern and corresponding
Trang 13indi-page
Raschke: You never want to limit
yourself in a strongly trending
market Look at Crude Oil or
Gold—there have been lots of
pull-backs, but the trend is still higher
You should be careful late in the
game because the security might be
ripe for a bigger shakeout, but you
try to differentiate whether it is a
normal trading environment or if a
really powerful force is at work
It takes a lot of time to reverse a
strong trend There is usually an
extended period of accumulation or
distribution, so it would be extremely rare that a trend reverses on a dime without plenty of advance warn-ing Trend reversals are a process that often shows up in classic chart formations like head and shoulders
or broadening formations
Vomund: Let me give you another
example to look at, the iShares sell 2000 (IWM)
Rus-Raschke: This has actually become
a better trading vehicle than the Nasdaq 100 (QQQQ) Let’s start
with the weekly chart for IWM
Remember, weekly charts offer cleaner, prettier, and more sym-metrical swings than charts with shorter time frames Using the longer time frame, you get smooth-
er data, less noise, and a clearer picture of the trend
The weekly chart is in a solid uptrend where all of the upswings are greater than the downswings (Figure 4) There have been strong corrections, but the ETF remained
in an uptrend That’s because for
an uptrend to reverse, the security must have a lower high, a lower low, and then turn down Because there are swings in a long-term uptrending pattern, weekly chart traders should trade the periods when the momentum indicator is increasing
You also have to be aware of what time frame you are trading on—someone using a weekly chart will just trade long while some-one using a fifteen-minute chart, although the security is in a long-term uptrend, may go short And IWM is one of the few ETFs that can be effectively day-traded
Looking at its fifteen-minute chart, the trend reversal that occurred
in early March was a great ing spot In Figure 5 at point 1, the security made a lower low The mo-mentum oscillator at point 2 was lower than previous swings, imply-ing the start of a bearish move Ac-tive traders can short the pullbacks
short-So a day-trader can short even though longer time frames show
an uptrending pattern You have to know your time frame You can see that fifteen-minute charts have a lot more noise in the data and don’t have the same rhythmic swings that the weekly chart does
Vomund: You’re right when you
say you are using simple classic technical analysis tools
Raschke: I have to be honest with
you; the stuff I do is so basic ever, this is what works for me There will always be books covering new forms of technical analysis but that doesn’t mean the simple clas-sical technical analysis techniques don’t work They worked in the past, they work now, and they will work
How-in the future
It doesn’t matter if you are a term aggressive professional or
short-Source: AIQ Systems
Weekly chart of iShares Russell 2000 fund with Momentum indicator plotted in
the lower window Time period is November 2002 through February 2006.
F igure 4 - EWJ 03/10/06
Trang 14a longer-term investor, success
depends on simply understanding
the basic swings You’ve noticed
I’m not using fancy indicators It is
more important to simply
under-stand the significance of the
pat-terns, whether the security is in an
uptrend with higher highs or in a
downtrend with lower lows
That’s all I’m doing I’m analyzing
supply and demand shifts by the
length of the swings, by whether
momentum is increasing or
de-creasing, by whether there are
higher highs or lower lows
Vomund: Whether you use
real-time, daily, or weekly charts, are
there some common themes for
managing a trade?
Raschke: Managing a trade means
two things: placing an initial stop
and following an exit strategy Here
are the common themes Back
test-ing and modeltest-ing price behavior
shows that the great majority of
the time maximum profitability is
achieved by playing for small wins
as opposed to shooting for a large
gain Few patterns test out where
one can play for a larger gain by
us-ing a trailus-ing stop type of strategy
Instead, our work shows that you
should at least be pulling up your stop to a break-even once the trade begins to work, and then have a mechanism that forces you to take profits
Our work shows that a tion of an initial fixed stop plus a time stop is ideal I often employ an eight bar time stop in conjunction with a fixed stop (i.e., using a ten-minute chart you use an eighty-minute time stop, using a daily chart you use an eight-day time stop, etc.) If a trade is not working
combina-in eight bars, then it can be exited
This is true regardless of what time frame you are using
Finally, it is important to minimize the risk of having a large loss You don’t ever want to take a large loss
Sometimes traders end up with a big loss because they were hoping for a big profit The best traders first learn how to play good de-fense
Vomund: What advice do you give
to those who want to trade ETFs?
Raschke: Go to where the action
is Don’t pick a dead market that
isn’t doing anything, hoping it will eventually break out You have so many markets available to you that you should find choices with nice readable swings Go to where the volatility is and where supply and demand imbalances exist One last consideration with ETFs is relative strength work The leaders con-tinue to remain the leaders while the dogs will tend to continue to underperform
For your average readers, I would also recommend to never get discouraged at the overwhelming amount of noise that there is in the market Classic technical analysis eliminates this noise Simply pull
up charts and examine the trend, and within the trend the individual swings You’ll see they are pretty predictable Of course it is always easier to see the swing patterns in hindsight, but with a little practice you’ll identify them as they develop
Source: AIQ Systems
Fifteen-minute chart of iShares Russell 2000 fund with Momentum indicator plotted in the lower window Trend reversal was apparent at point 1 and con- firmed by momentum low, point 2.
F igure 5 - ISHARES RUSSELL 2000 IND IWT
Trang 15page
Chapter
Steve Palmquist &
ETF Trading Techniques
Steve Palmquist is a full-time trader with twenty years of market
experience who puts his own money to work in the market every
day Steve has shared trading techniques and systems with investors
at seminars across the country as well as at presentations at the Traders
Expo He has published articles in Stocks & Commodities,
Traders-Jour-nal, the AIQ Opening Bell , and Working Money
Steve has developed a market adaptive trading approach that focuses
on analyzing the current market conditions and selecting the best tools
to use in the current environment He has developed and tested over a
dozen different systems that along with market-driven exit strategies
form the basis of his trading toolbox
Steve is the founder of www.daisydogger.com, a web site that provides
trading tips and techniques and publishes the Timely Trades Letter,
which is derived from the process of writing down his market outlook,
trading strategy, and trading setups prior to each trading day
Whenever I meet an inexperienced trader I am usually asked, “What is
the key to successful trading?” or “How do you pick good stocks?”
Inex-perienced traders are often in a never-ending search for a technique that
always wins When the technique they are using results in a few losing
trades, they decide it doesn’t work and move on to another Eventually
they give up or hire a fund manager If they hire a manager, then they
begin all over again—searching for the manager that always wins There
is no system that wins all the time, regardless of what the slick ads say
The experienced trader knows that making money in the market involves knowing what to trade, when to trade, and how to change techniques and trading styles based on current market conditions Using the same tech-niques and setups in all market conditions can churn your account and give you a lot of practice at taking drawdowns The market will not adapt
to us so the experienced trader learns how to adapt to the market If you don’t adapt to the market, it will eventually chew you up, along with your account
The first step in improving trading results is to realize that the market has three modes, and we need to develop trading styles for each of these different modes The market can be in an uptrend, defined as a set of higher highs and higher lows It can be in a downtrend, defined as a series
of lower highs and lower lows Or it can be in a trading range, where the price oscillates between areas of support and resistance After determin-ing which of the three modes the market is currently in, I select one of my trading tools that has been designed for and tested under those market conditions I also adjust my strategy for position sizing, profit taking, and number of positions in the account
Traders, like carpenters, need to have a toolbox with more than one tool
in order to get the job done Just as a carpenter won’t build a house using only a screwdriver, successful traders must pick the proper tools to use for the current market conditions My trading toolbox consists of more than
a dozen different trading techniques that have been carefully tested under each of the three market conditions The actual trading process during market hours is the simple part of the job; successful traders put in a lot
of work developing and testing systems before they ever place an order
TrADIng rAngE
An example of a trading range market is shown in Figure 6 During the first three months of 2006, the NASDAQ traded in a range bounded by resistance in the 2330 area and support in the 2238 area I use the NAS-DAQ for determining market conditions because it is representative of
Steve Palmquist
Trang 16both big and small-cap stocks The
Dow Jones Industrial Average and
the S&P 500 indexes are focused
solely on big-cap stocks, and thus
just represent a narrow slice of the
overall market The NASDAQ gives
a better representation of what is
going on in the overall market
The most profitable time to trade is
when the market is in a clear trend
When the market is in a trading
range, it carries a little more risk I
compensate for this risk by taking
smaller than normal positions Due
to the nature of a trading range,
it is also important to take profits quickly For most stocks to move
a considerable distance, they need the market to be trending In a trading range market such as Fig-ure 6, stocks and ETFs on average tend to retrace or base sooner This characteristic is one of the contrib-uting factors that keep the overall market in a range
Since ETFs tend to move shorter distances when the market is in a trading range, it makes sense to
take profits quickly An example
of this is shown in Figure 7, which shows the iShares Financial Servic-
es ETF (IYG) during the first three months of 2006 IYG had a nice run-up during February, reaching
a peak on February 27 During the following nine sessions, it pulled back or retraced on generally below average volume On March 13, it broke out of the pullback by form-ing a higher high on above aver-age volume The pullback pattern, consisting of a rapid price run-up followed by a low volume retrace-ment, is one of several trading
patterns that I use during trading range markets
Note that IYG tried to break out
of the pullback on March 03 and March 08 by making a higher high than the previous day, but the volume on both occasions was below average, making the pattern suspect The breakout on March 13, noted by the up arrow in Figure 7, made a higher high than the previ-ous day and did it on above average volume For traders, it is very im-portant to watch volume Volume represents the power, or interest, behind a move
Source: AIQ Systems
Example Trading Range (with Bollinger Bands)
F igure 6 - OCEXCH 03/28/06
Source: AIQ Systems
IYG Pullback Trading Setup (with Bollinger Bands)
F igure 7 - IYG 03/28/06
Trang 17page
Stocks triggering or breaking out
on low volume are generally
sus-pect This implies that there is not
much interest in the move, and
if there is little interest, then the
stock is less likely to keep moving
There are always counter examples,
but in general I trade with the
volume I want to see stocks
mov-ing up on increasmov-ing volume and
pulling back or retracing on
declin-ing volume
I define tradable pullback patterns
by a setup condition followed by a
trigger condition When the setup
conditions are met, it makes the
security interesting, and it goes
on my watch list When the
trig-ger conditions are met, I enter the
trade Some setups never
trig-ger, which is not a problem since
the market always provides more
interesting setups Trading is about
patterns, not particular stocks or
ETFs
The setup conditions for this type
of pullback trade are a rapid price
rise of at least two weeks with
sev-eral above average, volume up days,
followed by a pullback or
retrace-ment on generally below average
volume Stocks and ETFs that show
strong gap downs or pullbacks on
large volume are ignored; there are more fish in the sea
IYG, shown in Figure 7, met these setup conditions by running up from the $114 area to the $120 area between February 08 and Febru-ary 27, and after the run-up pulling back or retracing on below average volume—so it made my watch list
Once an ETF is on my watch list,
I set an alert to let me know when
it has made a higher high than the previous day The higher high is the first part of the trigger The second part of the trigger is
that the higher high occurs on increasing volume If both these conditions are met, then I take the trade
IYG made higher highs than the previous day on March 03 and March 08, but the volume was below average, so both trigger conditions were not met
On March 13, it made a higher high and the volume was above average, indicating that it was time
to enter a position (see up arrow in Figure 7)
To use this technique one needs
a way to estimate the volume on the day of the trigger The way I do
this is to recognize that there are thirteen half-hour trading periods
in the trading day, and also that the volume is generally larger in the first half hour than in subsequent periods Based on this information,
I have a series of multipliers for volume based on the time of day
At the end of the first half hour of trading, I multiply the volume at that point in time by ten to esti-mate the volume at the end of the day At the end of the first hour of trading, I estimate the day’s volume
by multiplying the current volume
by 6.5 After ninety minutes of trading, I multiply the volume
by 4.3, and after two hours use a multiplier
of 3.2, and so on This approach allows me
to estimate a stock’s or ETFs total daily volume at any interim point during the trading day
It is not necessary to sit in front of the trading screen all day I use an alerts screen to notify me when a setup on my watch list has made a higher high than the previous day, and then to estimate the volume using the technique outlined above
If the volume is estimated to be above average, then I have a valid
trigger and can consider taking
a position Note that many kers will email price alerts to cell phones, allowing you to trade from almost anywhere
bro-I do not enter a position unless
I know exactly where I will exit Immediately after entering a posi-tion, I set a stop loss order to take
me out and limit my losses if the pattern fails I also set a limit order
to take me out when the stock hits
a profit target The stop loss order
is always entered just under the lowest low of the setup pattern The profit target is set at different places depending on the current market conditions
In trading range market ments, stocks tend to make a quick move after the trigger, then pull-back again or base Because of this behavior, I typically set my limit order just under the recent high, just under the upper Bollinger Band, or under a key trendline or resistance level I do not enter or-ders for even numbers or numbers ending in five, since that is where most people enter and I want my order to be just under where the crowd has theirs
environ-In the case of IYG (Figure 7), the low of the setup pattern was $117.50
The market does not care about random numbers or percentages, but it does care about patterns.
Trang 18on March 07, so the stop should be
set just under this level at $117.39
If the setup fails and price reaches a
lower low, then the pattern will be
invalidated, and I no longer want
to be in the position My risk on
the trade is the difference between
the trigger price and the stop loss
Remember, the trigger occurred on
March 13 when IYG moved above
the previous day’s high on above
average volume Since the previous
day’s high was $118.60, my risk on
the trade is $118.60 minus $117.39,
or $1.21
I use the amount at risk, $1.21, to
help determine how many shares
to buy If I am willing to risk $500
on each trade, then I can buy 500
divided by 1.21, or 413 shares Each
trader has different account sizes
and financial situations and thus is
willing to risk different amounts on
each trade Determining the
maxi-mum amount you are willing to
risk on each trade is an important
part of trading
Trading is a statistical business,
where it is important to have a
system that wins more often than
it loses, and the average winning
trade gains more than the average
losing trade loses If these
condi-tions are met, then averaged over
the long term, the system is likely to
be profitable Any single trade may
or may not be profitable, but after
a number of trades, the statistics should prove out and the system should show a profit Recognizing the statistical nature of trading is one of the keys to success
Traders who risk half their account size on each trade may see some spectacular returns in the short run, but are highly likely to go broke in the long run There are old traders and bold traders, but few old bold traders
Let’s assume that with a large number of trades, a system can show eight losing trades in a row
If that is the case, I want to be able
to take this hit without risking my account or becoming emotional I use this information to determine the maximum amount I am will-ing to risk on any single trade If a
$12,000 drawdown would not risk
a trader’s account or cause him to lose sleep, then the most he should
be willing to risk on any single trade would be $12,000 divided by eight, or $1,500
In the case of the IYG trade, the spread between the trigger and the stop loss was $1.21, so the number
of shares to trade would be 1,500
divided by 1.21, or 1,239 shares In practice, I round these share num-bers to the nearest hundred
Remember, the stop loss is placed under the low of the setup pat-tern, not some random number or percentage The market does not care about random numbers or percentages, but it does care about patterns Let the pattern determine the stop loss, and let the maximum amount you are willing to risk on any single trade determine the number of shares to buy
After placing the stop order under the low of the setup pattern, I enter
a sell limit order at a profit target
In trading range markets, I am looking to take profits quickly, so the limit order is usually placed just under the high of the setup pattern,
or just under the upper Bollinger Band In the case of the IYG trade shown in Figure 7, I placed the limit order under the Bollinger Band at $120.74
The limit order was hit on the fourth day of the trade result-ing in a profit of $120.74 minus
$118.60, or $2.14 IYG moved to a new high of $121.20 two days later (see down arrow on Figure 7), then
started another pullback to a low
of $118.65 on March 29 Forget about getting out at the exact high;
it can’t be done consistently ever, this technique captured most
How-of the move and resulted in a much better profit than if we had held for another two weeks
When the market is oscillating between support and resistance, traders should focus on taking quick profits and moving on to the next trade Making a number
of small profits during a trading range market can be much more profitable than blindly buying and holding, hoping for the best Hope
is not a trading technique, taking profits is Letting positions run and longer-term holding are for trend-ing market environments, not trad-ing range markets
With stocks and ETFs that trade
on low volume (less than 100,000 shares a day), I will consider using
a mental stop rather than entering the stop order Very low volume se-curities can sometimes be manipu-lated, so caution is warranted With higher volume securities, I usually enter on a market order With low
Trang 19page
volume securities, I always use a
limit order to enter a new position
The OCO, or “order cancels order,”
entry is ideal for traders After
taking a trade I enter both the stop
and the limit orders using this
or-der type If either one is executed,
then the other order is cancelled
This allows me to take a trade,
en-ter the exit parameen-ters, and let the
broker’s computer keep an eye on
things for me while I do something
else Most brokers offer the OCO
trade entry If yours doesn’t,
con-sider changing brokers
Figure 8 shows another example
of trading pullback setups during
a trading range market
environ-ment In Figure 8, iShares
Health-care (IYH) showed a nice run-up
between February 07, 2006 and
February 27, 2006, then pulled
back or retraced for six sessions As
IYH started pulling back after the
run-up, it made my watch list as
an interesting setup On March 08,
it moved above the previous day’s
high of $64.15 on above average
volume, which constituted a trigger
condition (see arrows)
When IYH triggered on good
volume, the trade could be entered
at $64.20, slightly above the vious day’s high After entering the trade, a stop should be placed under the low of the setup pat-tern The low of the pattern was
pre-$63.75 on March 07, so a stop order was entered for $63.64 to protect against pattern failure
The difference between the entry
at $64.20 and the stop at $63.64 was $0.56 If the maximum amount a trader is willing to risk on any single trade is $500, then the amount purchased should
of the trigger I would use a limit order of $65.39
After the trigger, IYH continued to move up and hit the $65.39 level on the eighth day of the trade, caus-ing the limit order to be executed
It reached a high for this run the following day and then started an eight-day pullback that took it back under the trigger price Holding
this stock for sixteen days would have resulted in no gain Using the techniques outlined above resulted
in a profit of $1.19 in eight days A
2 % profit in eight days keeps food
on the table; repeating this a ber of times during a trading range market puts money in the bank
num-TrEnDIng MArKETS
Trading range markets do not last forever Eventually the market will break above resistance or below support When this happens, I start looking for signs that the market
is establishing a trend, defined as
a series of higher highs and higher lows (uptrend) or a series of lower lows and lower highs (downtrend) Trending markets can be quite profitable for traders because they represent less risk than trading range markets and positions may
be held longer
One of the keys to trading is to adjust the position sizing and hold-ing times for trades depending on the market conditions In trading range markets, I often use half-size positions and holding times may be measured in days In trending mar-kets, I use full-size positions and
Source: AIQ Systems
IYH Pullback Trading Setup (with Bollinger Bands)
F igure 8 - IYH 03/31/06
Trang 20holding times may be measured in
weeks This is part of adapting to
the market Trading the same way
in all market conditions is likely to
just churn your account
It is amazing how many people tell
me they are short-term traders, or
swing traders, or long-term
trad-ers You can’t decide what you’re
going to be, then force your ideas
on the market You must look at
what the market is doing, and then
pick a style that is profitable for the
current conditions If the market is
range bound, I will be a short-term
or a swing trader If the market
is strongly trending, I will hold
longer and take larger positions
My style of trading is determined
by the market If you use the same
style all the time, you are likely to
eventually take a hit Adapt to the
market—it will not adapt to you
Figure 9 shows a period between
October 15, 2004 and January 04,
2005 when the market was in an up
trend The market was in a small
basing area during the middle of
October It broke above this
bas-ing area on October 27, 2004 and
continued to make a series of
higher highs and higher lows for
the remainder of the year When the market is trending, I give my trades more room to run and take larger positions than I do in a trad-ing range market
When the market is trending, I also trade more types of patterns
For example, base breakouts are usually not interesting in a trading range market, but are one of the patterns I look for when the market
is trending As shown in Figure
10, iShares Technology (IYW) had formed a narrow base during Oc-tober On October 28, 2004, IYW
moved above the top of the recent range on twice-average volume (see arrow) Since volume measures the pressure behind or interest in
a move, the break from a trading range on twice-average volume is a significant event
Imagine you are running a ing store, and you have a rack of red shirts and another rack of green shirts During the last month, you have been selling a few of each kind
cloth-at the same price One day there is a run on red shirts, and you sell out
Which do you order more of?
Obvi-ously, there is a strong and sudden demand for red shirts, so you want
to have more of them around to meet the new demand
Does it matter to you why red shirts are suddenly selling? No, you are just in a hurry to get more You are also likely to realize that
if red shirts are suddenly in mand, you can likely charge more for them, so you raise the price High demand leads to higher prices When there isn’t demand for something, the price drops The slow moving shirts are put on sale
de-to clear the invende-tory
The same supply and demand sues drive the stock market Dur-ing the month of October, there was light demand for IYW On Oc-tober 28, suddenly twice as many people wanted it It doesn’t matter why The point is; it’s selling fast just like the red shirts The demand has increased, and so the price is likely to increase also
is-When a security is in a trading range, it indicates that most people believe it is fairly priced Supply and demand are roughly equal When it breaks above the trading range on strong volume, it indicates
Source: AIQ Systems
NASDAQ Uptrend Period (with Bollinger Bands)
F igure 9 - OCEXCH 01/04/05
Trang 21page
that a lot more buyers have come
in and are willing to pay more
for the security They believe it is
undervalued and are picking it up
Dollars are votes—they are voting
to raise the price of the security
When the market is in an uptrend,
I may enter ETFs and stocks that
are breaking out of basing areas
After breaking out of a basing area
on October 28, IYW ran up for
another month During favorable
market conditions, ETFs tend to
run longer, so I increase my
hold-ing time and also my position sizes
for each trade During trending
markets, I do not take profits as
po-sitions hit the upper Bollinger Band
because, instead of dropping back,
they tend to “ride” the bands
In trending markets, I use
top-ping patterns and trendlines to
determine when to exit positions
Double tops, head and shoulders,
rat tails, and volume distribution
patterns offer good clues that it is
time to exit a position A
distribu-tion day occurs when the stock is
down on volume larger than the
pervious day I have found that
an occasional distribution day is
not necessarily significant, but
my research indicates that three distribution days in the past ten sessions is a good indicator that the current run may be ending If
I see three distribution days in the past ten sessions, then I need a very good reason to continue holding the position
“Rat tails” occur when the stock runs up well past the open then pulls back to close near, or even be-low, the opening price On a can-dlestick chart, these are shown as long upper shadows They happen because the stock was bid up sig-nificantly during the day but then ran into selling pressure and pulled back When this happens repeat-edly, it shows a lack of strength
When a stock shows a lack of strength, I exit the position and move on to another I want to take profits as a stock’s run weakens and move my money into something that is stronger or just starting its run Remember the red shirts
On the IYW chart (Figure 10), “rat tails” appear three days in a row in early December, as marked by the
up arrow When I see this kind of pattern after a nice run, I exit the position IYW had run up for about
a month before showing the “rat tails,” so when I saw them, it was clear that something was changing, and it was time to exit the position and move on The “rat tail” pattern was in fact the peak for IYW, and
it began a slow decline that took it back below the initial base break-out in late January
A “buy and holder” who took a position during the breakout in late October would have seen a nice profit by early December, then would have watched it turn into
a loss by late January In fact, it would take another year for the
price to return to the highs reached
in early December The market generally gives good clues on when
to get in and when to get out Buy and hold equals buy and hope, and hope is not a trading strategy Rather than buy and hope, I enter when the security shows increased interest in bidding up the price and exit when topping patterns indicate the process may reverse Rather than tying up my money for long periods, I enter and exit based on trading patterns When one pat-tern is complete, I move on to the next one
Source: AIQ Systems
IYW Base Trading Pattern (with Bollinger Bands)
F igure 10 - IYW 12/31/04